Big Banks Should Increase Capital Now Before The Next Downturn

Current economic growth and record high bank earnings justify U.S. bank regulators requiring systemically important banks to start allocating more capital to sustain unexpected losses that result when an economic or market downturn occur. In 2010, the Basel Committee on Banking Supervision (BCBS), the international standards setter for banks, included a countercyclical capital buffer as part of the global capital and liquidity framework, Basel III. The BCBS recommends that regulators trigger the countercyclical buffer for banks in their jurisdiction when countries are in an expansionary part of the credit cycle and that they decrease the buffer when an economy is slowing down.

The purpose of the countercyclical capital buffer is “to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. Its primary objective is to use a buffer of capital to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that have often been associated with the build-up of system-wide risk.” Importantly, due to its countercyclical nature, “the countercyclical capital buffer regime may also help to lean against the build-up phase of the credit cycle in the first place. In downturns, the regime should help to reduce the risk that the supply of credit will be constrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system.”

Presently, U.S. macroeconomic factors support that we are at the expansionary part of the credit cycle; we may even be at the peak. Second quarter 2018 GDP was 4.1%, and July’s unemployment rate of 3.9 is very close to its lowest level in 18 years. We should not be surprised then that very positive macroeconomic factors, coupled with a rising rate environment and a significant tax cut, banks in the U.S. are currently extremely profitable. The Chair of the Federal Deposit Insurance Corporation (FDIC), Jelena, announced last Thursday that the 5,542 banks that the FDIC insures reported second quarter net income of $60.2 billion, 25% higher than the same period in 2017, and breaking last quarter’s historic record. In fact, bank earnings have been rising most quarters since the second quarter of 2016 as shown in FDIC graphs.

Some headwinds to watch carefully, which could adversely impact banks’ balance sheets and earnings, can be found in the components of GDP and several key housing data. The data show that a slowing of the U.S. growth rate is around the corner. While second quarter GDP numbers were very good, a big reason for exports increasing in the second quarter was because U.S. companies were hurrying to export ahead of retaliatory tariffs from other countries due to Trump having announced tariffs on Canada, China, Europe, and Mexico. It is unlikely that we will see such a rise in exports in the second half of this year unless somehow Trump were to take back his tariff threats. A number of businesses have already announced lay-offs or decreases in investments; hence, banks need to brace for Trump’s tariffs and should analyze how many of their borrowers could be adversely impacted by the tariffs.

Personal consumption expenditures, a big contributor to U.S. GDP, is also likely to slow down as interest rates rise which make credit cards and any new loans more expensive for consumers. Moreover, anyone working in an export supported job especially in states in the Midwest and the South are likely to spend less due to the uncertainty about their jobs which are sensitive to Trump’s tariffs.

Recent housing data should also be of concern to banks’ risk managers. In July, housing starts rose almost only about 1% in comparison to July 2017. In June, housing starts tumbled to their lowest level in nine months; the 12% decline was much more than had been anticipated. Economist and Head of Analytics at Rutter Associates, Robert Selvaggio explains that “Housing starts are a key leading indicator for the macroeconomy, because residential fixed investment represents about 20% of total U.S. gross private domestic investment and the housing sector overall accounts for about 15% of total U.S. GDP. Homebuilders do not start new projects when they fear an oncoming economic downturn, and potential homebuyers reduce their demands for new homes when they fear stock market and employment instabilities.”

New home sales, of 627,000 in July 2018 are about 12.8% higher than they were in July 2017, but new home sales have been decreasing since November 2017 and are now at a nine-month low. New home sales get tabulated when contracts get signed and represent about 10% of all home sales in the US. Existing home sales this July decreased .7% in comparison to July; this is the fourth monthly decrease and existing home sales are now at their lowest level in two years.

Another important headwind can be found in banks’s weakening underwriting standards. All three national bank regulators have recently reported weaknesses in banks underwriting standards. According to the Office of the Comptroller of the Currency in itsSemiannual Risk Perspective, “Competition for quality loans is strong, however, and examiners note evidence of eased underwriting, increased [commercial real estate] CRE concentration limits, and a higher level of [matter requiring attention] MRA concerns related to policy exceptions.” Respondents to the Federal Reserve’s July 2018 Senior Loan Officers Survey stated that regarding loans to businesses they “eased their standards and terms on commercial and industrial (C&I) loans to firms of all sizes and kept commercial real estate (CRE) lending standards about unchanged on balance.” And last week, FDIC Chair McWilliams made a statement that “The competition to attract loan customers will be intense, and it will remain important for banks to maintain their underwriting discipline and credit standards.”

I am more convinced than ever that the time to trigger the countercyclical buffer is now. I am not the only person advocating this point of view. Gregg Gelzinis, Research Associate at The American Center for Progress, in a MarketWatch opinion piece in early August, and more recently Jason Furman, Professor of the Practice of Economic Policy at Harvard University, in a Wall Street Journal opinion piece, also presented their reasons in support of the countercyclical buffer.

In the over 25 years that I have worked in finance, I have witnessed that waiting until there is an economic downturn or a market crisis, to start raising capital buffers, is too late.

U.S. Banks Post Record Earnings

FDIC

At such times, lenders panic and lend less to individuals and business, and what they do lend will be at a higher rate. This behavior leads to a significant and economic contraction. Time and again we see that particularly in a crisis all lenders behave in the same way driving us deeper and longer into a recession. The Basel Committee’s intent with the countercyclical buffer is to mitigate the effects of procyclicality of risk weighting assets higher which causes banks to increase capital allocations and decrease lending. In a downturn, the Basel Committee recommends that regulators lower the countercyclical buffer, precisely so that banks can continue lending to credit worthy individuals and companies. I urge bank regulators not to repeat the mistakes of the past and to start triggering the countercyclical capital buffer now before it is too late.